Global Equity Income 2018 Outlook

As markets shrugged off geopolitical tensions and continued to rise, Mark Whitehead reflects on what 2017 meant for income investors and what lies ahead in 2018.

11 January 2018

What were the key drivers of markets last year?

Strong momentum and low volatility led to very positive total returns for the market in 2017, making it a fantastic year for investors’ risk-adjusted returns. A synchronised global upswing in economic activity and some strong earnings quarters drove outperformance of cyclical sectors. Our strategy has high allocations to a number of these stocks and benefited as a result – financials, materials and industrials sectors all producing strong absolute returns for the portfolio.

Technology was a big driver of the market and the bestperforming sector overall for the year. Needless to say, this is an area where dividend investors have historically struggled to gain exposure, but where we have, nevertheless, identified attractive opportunities. Indeed, a handful of large technology names producing aggressive dividend growth, provided strong absolute returns for the strategy.

However, the theme of disruption (from e-commerce and internet names in the technology sector) has been a big headwind for companies in the consumer space. Firms in areas such as media, retail and discretionary, where the strategy has holdings, have suffered from the impact of increased competition. Traditional income sectors, such as telecommunications and real estate have also struggled to keep pace with the wider market (although real estate was a strong contributor for the portfolio over the year).*

Did your strategy perform as you would have expected in 2017?

In terms of style, high-dividend stocks lagged the wider market in 2017. The strategy, which has a high yield, was around the median level for the peer group.

Over the course of the second half of 2016 and early 2017 we re-positioned the portfolio to maximise its dividendgrowth potential, increasing the weighting to more cyclically sensitive sectors, such as technology and materials. As a result, with higher forecast growth potential, the total return of the fund has improved over the last year. It is also pleasing that the strategy has produced some attractive dividend growth for shareholders.

The best-performing region both at a market and portfolio level was Europe. North American equities, meanwhile somewhat lagged other markets. This is a region where we find it harder to find higher yield and we selectively reduced our average weighting to below 50%, in favour of European and Asian companies. Our stock selection in North America, driven by US energy and consumer names, was disappointing. Energy companies were impacted by weak oil prices earlier in the year and consumer names by the widespread disruption from technology names.*

Due to the disruption mentioned previously, the consumer space was difficult to navigate for many investors in 2017, and we pulled back from investing in some attractively valued names, which became cheaper as the year progressed. Similarly, we were also quick to cut some stocks that had started to perform poorly.

What do you think will be the key drivers for your markets in 2018?

Economic conditions have been strong in the past year, and we expect this to continue into 2018. The US could accelerate the fastest with business activity rebounding, capital expenditure improving and a resurgence of Keynes’ ‘animal spirits’ (positive sentiment in the market), as corporate tax changes are implemented.

This economic backdrop should bode well for corporate activity and thus earnings growth should remain positive. We believe this has to be the case as equity markets are expensive on a number of different short and longerterm valuation measures and cannot continue to be driven by multiple expansion, as has been the case over the past seven years.

China’s role will be vital, as it has been injecting huge levels of liquidity into its economy over the past year. While this has not increased its own economic growth, it has arguably been responsible for much of the global upswing in economic activity in 2017. As a result, if Beijing's policies are reversed, this may well cause a wider slowdown.

We are also watching central banks very carefully; in particular, the US Federal Reserve, as it embarks on the withdrawal of stimulus provisions, through the tapering of quantitative easing. This could cause yield curves to rise and steepen and introduce volatility into asset markets, a marked change from the particularly benign level of volatility we have witnessed over much of the year.

Cyclical sectors, meanwhile, should continue to perform well, driven by the industrials, materials, technology and financials sectors.

How are earnings revisions and valuations looking relative to historic averages and other markets?

Earnings revisions continue to look positive and have been in an improving trend since February 2017. The strongest revisions to expected earnings globally are coming from the more cyclical areas of the market for 2018 – materials and technology have the strongest earnings upgrades for 2018. Traditionally more defensive, low-growth sectors have not seen the same level of revisions with healthcare and telecoms relatively stable.

Many market commentators are bemoaning how expensive global equity markets have become, and on many measures it's difficult to disagree. For example, the US Cyclically Adjusted Price to Earnings (CAPE) ratio, based on the S&P 500 index, is currently over 30x and has only been at a higher level twice before – in September 1929 prior to the Great Depression and December 1999, just before the dot-com bubble burst.††

Earnings revisions continue to look positive and have been in an improving trend since February 2017. The strongest earnings revisions globally are coming from the more cyclical areas of the market for 2018.*

However, we believe this current period is somewhat different, as equities look much cheaper relative to other asset classes, such as real 10-year governmentbond yields (minus inflation rate) – which are currently negative for the UK, Germany and Japan and only just in positive territory for the US. We also do not see evidence of any sector which is absurdly overvalued. Of course, some of the high-profile tech giants do look expensive – and have driven a large proportion of the past year’s total return – but a correction in these names is unlikely to drive a recessionary-type response from the wider equity market.

We are also able to derive intrinsic upside in our own company valuation models, using fairly conservative assumptions on cost of capital and growth rates. These, combined with our own and consensus expectations for strong dividend growth in 2018,** gives us confidence we are not about to witness a large market correction.

What are the biggest risks to your markets in 2018?

There are a number of ‘known unknowns’ which investors will be aware of, including politics, the risks of terrorism and tensions on the Korean Peninsula. Donald Trump’s destabilising influence on the world stage does concern us. His decision to move the US Embassy in Israel to Jerusalem, for example, was widely condemned (and could fan the flames of geopolitical rhetoric). In the UK, the Brexit negotiations moving into the second phase ahead of the final ‘divorce’, could be very tricky and cumbersome. There is much to work out in terms of trade treaties, healthcare, movement of labour and more, all of which will be very important for the UK’s economy and international standing for generations to come.

In terms of other potential risks, central bank policy error (by raising interest rates and withdrawing quantitative-easing stimulus too quickly) could lead to a disorderly sell-off in bond markets – causing a de-rating of equity markets; a slowdown in China (which could come from Chinese credit tightening) could potentially cause global growth to falter; and there is the risk of an earnings slowdown. At a company level, technology disruption continues to upset traditional ‘old-economy’ businesses. This could have a destabilising effect in a number of areas, including labour trends, inflation, social wellbeing and politics.

What sustainability themes do you see yourself engaging with companies on most in 2018?

As a reminder, we believe companies with robust sustainability practices demonstrate better operational performance, which ultimately translates into cash flows (and dividends). It is also the case that prudent sustainability practices have a positive influence on investment performance.

We engage with companies on a wide range of environmental, social and governance (ESG) matters, with the most material issues naturally varying from company to company. There will, of course, be some common themes which we are focusing on. These include management remuneration (whether pay is aligned with company strategy and in line with sustainable business practices) and the independence of management boards (and whether there is an avoidance of overboarding or board entrenchment). There's also the issue of labour management, with a key focus being companies that acquire other firms and are initiating cost-cutting programmes. Finally, there's the theme of pollution, particularly as it relates to greenhouse gas emissions (climate change), an area that brings both huge risks for companies and opportunities.

*Source: Martin Currie over 12 months to 31 December 2017. Source: FactSet and Lipper IM as at 31 December 2017. Peer group is IA Global Equity Income.
Source: FactSet and Lipper IM as at 31 December 2017. Peer group is IA Global Equity Income. ††Source: Robert Shiller, Yale. **Source: UBS PAS. Benchmark: MSCI AC World Index (as at 29 September 2017).

More information on the strategy

Global Equity Income update - Jan 2018 Play Play Video
Global Equity Income January 2018 update

Important information

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